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Reg. Section 1.263(a)-3(k)(7), Example 15
Amounts paid to improve tangible property.
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(k)Capitalization of restorations.
(1)In general. A taxpayer must capitalize as an improvement an amount paid to restore a
unit of property, including an amount paid to make good the exhaustion for which an
allowance is or has been made. An amount restores a unit of property only if it(i) Is for the replacement of a component of a unit of property for which the
taxpayer has properly deducted a loss for that component, other than a casualty
loss under §1.165-7;
(ii) Is for the replacement of a component of a unit of property for which the
taxpayer has properly taken into account the adjusted basis of the component in
realizing gain or loss resulting from the sale or exchange of the component;
(iii) Is for the restoration of damage to a unit of property for which the taxpayer is
required to take a basis adjustment as a result of a casualty loss under section 165,
or relating to a casualty event described in section 165, subject to the limitation in
paragraph (k)(4) of this section;
(iv) Returns the unit of property to its ordinarily efficient operating condition if
the property has deteriorated to a state of disrepair and is no longer functional for
its intended use;
(v) Results in the rebuilding of the unit of property to a like-new condition as
determined under paragraph (k)(5) of this section after the end of its class life as
defined in paragraph (i)(4) of this section; or
(vi) Is for the replacement of a part or combination of parts that comprise a major
component or a substantial structural part of a unit of property as determined
under paragraph (k)(6) of this section.
(2)Application of restorations to buildings. An amount is paid to improve a building if it
is paid to restore, as defined under paragraph (k)(1) of this section, a property specified
under paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph
(e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or portion of
building) of this section. For example, an amount is paid to improve a building if it is
paid for the replacement of a part or combination of parts that comprise a major
component or substantial structural part of the building structure or any one of its
building systems (for example, the HVAC system). See paragraph (k)(6) of this section.
(3)Exception for losses based on salvage value. A taxpayer is not required to treat as a
restoration amounts paid under paragraph (k)(1)(i) or paragraph (k)(1)(ii) of this section
if the unit of property has been fully depreciated and the loss is attributable only to
remaining salvage value as computed for federal income tax purposes.
(4)Restoration of damage from casualty.
(i) Limitation. For purposes of paragraph (k)(1)(iii) of this section, the amount
paid for restoration of damage to the unit of property that must be capitalized
under this paragraph (k) is limited to the excess (if any) of(A) The amount prescribed by §1.1011-1 as the adjusted basis of the
single, identifiable property (under §1.167-7(b)(2)(i)) for determining the
loss allowable on account of the casualty, over
(B) The amount paid for restoration of damage to the unit of property
under paragraph (k)(1)(iii) of this section that also constitutes an
improvement under any other provision of paragraph (k)(1) of this section.
(ii) Amounts in excess of limitation. The amounts paid for restoration of damage
to a unit of property as described in paragraph (k)(1)(iii) of this section, but that
exceed the limitation provided in paragraph (k)(4)(i) of this section, must be
treated in accordance with the provisions of the Internal Revenue Code and
regulations that are otherwise applicable. See, for example, §1.162-4 (repairs and
maintenance); §1.263(a)-2 (costs to acquire and produce units of property); and
§1.263(a)-3 (costs to improve units of property).
(5)Rebuild to like-new condition. For purposes of paragraph (k)(1)(v) of this section, a
unit of property is rebuilt to a like-new condition if it is brought to the status of new,
rebuilt, remanufactured, or a similar status under the terms of any federal regulatory
guideline or the manufacturer's original specifications. Generally, a comprehensive
maintenance program, even though substantial, does not return a unit of property to a
like-new condition.
(6)Replacement of a major component or a substantial structural part.
(i) In general. To determine whether an amount is for the replacement of a part or
a combination of parts that comprise a major component or a substantial structural
part of the unit of property under paragraph (k)(1)(vi) of this section, it is
appropriate to consider all the facts and circumstances. These facts and
circumstances include the quantitative and qualitative significance of the part or
combination of parts in relation to the unit of property.
(A) Major component. A major component is a part or combination of
parts that performs a discrete and critical function in the operation of the
unit of property. An incidental component of the unit of property, even
though such component performs a discrete and critical function in the
operation of the unit of property, generally will not, by itself, constitute a
major component.
(B) Substantial structural part. A substantial structural part is a part or
combination of parts that comprises a large portion of the physical
structure of the unit of property.
(ii) Major components and substantial structural parts of buildings. In the case of
a building, an amount is for the replacement of a major component or a
substantial structural part of the building unit of property if(A) The replacement includes a part or combination of parts that comprise
a major component (as defined in paragraph (k)(6)(i)(A) of this section),
or a significant portion of a major component, of any of the properties
designated in paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B)
(condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph
(e)(2)(v)(B) (leased building or leased portion of a building) of this
section; or
(B) The replacement includes a part or combination of parts that
comprises a large portion of the physical structure of any of the properties
designated in paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B)
(condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph
(e)(2)(v)(B) (leased building or portion of building) of this section.
(7)Examples. The following examples illustrate the application of this paragraph (k) only
and do not address whether capitalization is required under another provision of this
section or another provision of the Code (for example, section 263A). Unless otherwise
stated, assume that the taxpayer has not properly deducted a loss for, nor taken into
account the adjusted basis on a sale or exchange of, any unit of property, asset, or
component of a unit of property that is replaced.
Example (1). Replacement of loss component. A owns a manufacturing building
containing various types of manufacturing equipment. A does a cost segregation study of
the manufacturing building and properly determines that a walk-in freezer in the
manufacturing building is section 1245 property as defined in section 1245(a)(3). The
freezer is not part of the building structure or the HVAC system under paragraph (e)(2)(i)
or (e)(2)(ii)(B)(1) of this section. Several components of the walk-in freezer cease to
function, and A decides to replace them. A abandons the old freezer components and
properly recognizes a loss from the abandonment of the components. A replaces the
abandoned freezer components with new components and incurs costs to acquire and
install the new components. Under paragraph (k)(1)(i) of this section, A must capitalize
the amounts paid to acquire and install the new freezer components because A replaced
components for which it had properly deducted a loss.
Example (2). Replacement of sold component. Assume the same facts as in Example 1,
except that A did not abandon the components but instead sold them to another party and
properly recognized a loss on the sale. Under paragraph (k)(1)(ii) of this section, A must
capitalize the amounts paid to acquire and install the new freezer components because A
replaced components for which it had properly taken into account the adjusted basis of
the components in realizing a loss from the sale of the components.
Example (3). Restoration after casualty loss. B owns an office building that it uses in its
trade or business. A storm damages the office building at a time when the building has an
adjusted basis of $500,000. B deducts under section 165 a casualty loss in the amount of
$50,000, and properly reduces its basis in the office building to $450,000. B hires a
contractor to repair the damage to the building, including the repair of the building roof
and the removal of debris from the building premises. B pays the contractor $50,000 for
the work. Under paragraph (k)(1)(iii) of this section, B must treat the $50,000 amount
paid to the contractor as a restoration of the building structure because B properly
adjusted its basis in that amount as a result of a casualty loss under section 165, and the
amount does not exceed the limit in paragraph (k)(4) of this section. Therefore, B must
treat the amount paid as an improvement to the building unit of property and, under
paragraph (d)(2) of this section, must capitalize the amount paid.
Example (4). Restoration after casualty event. Assume the same facts as in Example 3,
except that B receives insurance proceeds of $50,000 after the casualty to compensate for
its loss. B cannot deduct a casualty loss under section 165 because its loss was
compensated by insurance. However, B properly reduces its basis in the property by the
amount of the insurance proceeds. Under paragraph (k)(1)(iii) of this section, B must
treat the $50,000 amount paid to the contractor as a restoration of the building structure
because B has properly taken a basis adjustment relating to a casualty event described in
section 165, and the amount does not exceed the limit in paragraph (k)(4) of this section.
Therefore, B must treat the amount paid as an improvement to the building unit of
property and, under paragraph (d)(2) of this section, must capitalize the amount paid.
Example (5). Restoration after casualty loss; limitation.
(i) C owns a building that it uses in its trade or business. A storm damages the
building at a time when the building has an adjusted basis of $500,000. C
determines that the cost of restoring its property is $750,000, deducts a casualty
loss under section 165 in the amount of $500,000, and properly reduces its basis
in the building to $0. C hires a contractor to repair the damage to the building and
pays the contractor $750,000 for the work. The work involves replacing the entire
roof structure of the building at a cost of $350,000 and pumping water from the
building, cleaning debris from the interior and exterior, and replacing areas of
damaged dry wall and flooring at a cost of $400,000. Although resulting from the
casualty event, the pumping, cleaning, and replacing damaged drywall and
flooring, does not directly benefit and is not incurred by reason of the roof
replacement.
(ii) Under paragraph (k)(1)(vi) of this section, C must capitalize as an
improvement the $350,000 amount paid to the contractor to replace the roof
structure because the roof structure constitutes a major component and a
substantial structural part of the building unit of property. In addition, under
paragraphs (k)(1)(iii) and (k)(4)(i), C must treat as a restoration the remaining
costs, limited to the excess of the adjusted basis of the building over the amounts
paid for the improvement under paragraph (k)(1)(vi). Accordingly, C must treat as
a restoration $150,000 ($500,000-$350,000) of the $400,000 paid for the portion
of the costs related to repairing and cleaning the building structure under
paragraph (k)(1)(iii) of this section. Thus, in addition to the $350,000 to replace
the roof structure, C must also capitalize the $150,000 as an improvement to the
building unit of property under paragraph (d)(2) of this section. C is not required
to capitalize the remaining $250,000 repair and cleaning costs under paragraph
(k)(1)(iii) of this section.
Example (6). Restoration of property in a state of disrepair. D owns and operates a farm
with several barns and outbuildings. D did not use or maintain one of the outbuildings on
a regular basis, and the outbuilding fell into a state of disrepair. The outbuilding
previously was used for storage but can no longer be used for that purpose because the
building is not structurally sound. D decides to restore the outbuilding and pays an
amount to shore up the walls and replace the siding. Under paragraphs (e)(2)(ii) and
(k)(2) of this section, an amount is paid to improve a building if the amount is paid to
restore the building structure or any building system. The walls and siding are part of the
building structure under paragraph (e)(2)(ii)(A) of this section. Under paragraph
(k)(1)(iv) of this section, D must treat the amount paid to shore up the walls and replace
the siding as a restoration of the building structure because the amounts return the
building structure to its ordinarily efficient operating condition after it had deteriorated to
a state of disrepair and was no longer functional for its intended use. Therefore, D must
treat the amount paid to shore up the walls and replace the siding as an improvement to
the building unit of property and, under paragraph (d)(2) of this section, must capitalize
the amount paid.
Example (7). Rebuild of property to like-new condition before end of class life. E is a
Class I railroad that owns a fleet of freight cars. Assume the freight cars have a recovery
period of 7 years under section 168(c) and a class life of 14 years. Every 8 to 10 years, E
rebuilds its freight cars. Ten years after E places the freight car in service, E performs a
rebuild to the manufacturer's original specification, which includes a complete
disassembly, inspection, and reconditioning or replacement of components of the
suspension and draft systems, trailer hitches, and other special equipment. E also
modifies the car to upgrade various components to the latest engineering standards. The
freight car is stripped to the frame, with all of its substantial components either
reconditioned or replaced. The frame itself is the longest-lasting part of the car and is
reconditioned. The walls of the freight car are replaced or are sandblasted and repainted.
New wheels are installed on the car. All the remaining components of the car are restored
before they are reassembled. At the end of the rebuild, the freight car has been restored to
like-new condition under the manufacturer's specifications. Assume the freight car is the
unit of property. E is not required to treat as an improvement and capitalize the amounts
paid to rebuild the freight car under paragraph (k)(1)(v) of this section because, although
the amounts paid restore the freight car to like-new condition, the amounts were not paid
after the end of the class life of the freight car. However, paragraphs (k)(1)(vi) and (k)(6)
of this section are applicable for determining whether any amounts must be capitalized
because they are paid for the replacement of a major component or a substantial structural
part of the unit of property.
Example (8). Rebuild of property to like-new condition after end of class life. Assume the
same facts as in Example 7, except that E rebuilds the freight car 15 years after E places
it in service. Under paragraph (k)(1)(v) of this section, E must treat as an improvement
and capitalize the amounts paid to rebuild the freight car because the amounts paid
restore the freight car to like-new condition after the end of the class life of the freight
car.
Example (9). Not a rebuild to a like-new condition. F is a commercial airline engaged in
the business of transporting freight and passengers. To conduct its business, F owns
several aircraft. As a condition of maintaining its airworthiness certificates, F is required
by the FAA to establish and adhere to a continuous maintenance program for each
aircraft in its fleet. F performs heavy maintenance on its airframes every 8 to 10 years. In
Year 1, F purchased an aircraft for $15 million. In Year 16, F paid $2 million for the
labor and materials necessary to perform the second heavy maintenance visit on the
airframe of an aircraft. To perform the heavy maintenance visit, F extensively
disassembles the airframe, removing items such as engines, landing gear, cabin and
passenger compartment seats, side and ceiling panels, baggage stowage bins, galleys,
lavatories, floor boards, cargo loading systems, and flight control surfaces. As specified
by F's maintenance manual for the aircraft, F then performs certain tasks on the
disassembled airframe for the purpose of preventing deterioration of the inherent safety
and reliability levels of the airframe. These tasks include lubrication and service,
operational and visual checks, inspection and functional checks, reconditioning of minor
parts and components, and removal, discard, and replacement of certain life-limited
single cell parts, such as cartridges, canisters, cylinders, and disks. Reconditioning of
parts includes burnishing corrosion, repairing cracks, dents, gouges, punctures, tightening
or replacing loose or missing fasteners, replacing damaged seals, gaskets, or valves, and
similar activities. In addition to the tasks described above, to comply with certain FAA
airworthiness directives, F inspects specific skin locations, applies doublers over small
areas where cracks were found, adds structural reinforcements, and replaces skin panels
on a small section of the fuselage. However, the heavy maintenance does not include the
replacement of any major components or substantial structural parts of the aircraft with
new components. In addition, the heavy maintenance visit does not bring the aircraft to
the status of new, rebuilt, remanufactured, or a similar status under FAA guidelines or the
manufacturer's original specifications. After the heavy maintenance, the aircraft was
reassembled. Assume the aircraft, including the engines, is a unit of property and has a
class life of 12 years under section 168(c). Although the heavy maintenance is performed
after the end of the class life of the aircraft, F is not required to treat the heavy
maintenance as a restoration and improvement of the unit of property under paragraph
(k)(1)(v) of this section because, although extensive, the amounts paid do not restore the
aircraft to like-new condition. See also paragraph (i)(1)(iii) of this section for the
application of the safe harbor for routine maintenance.
Example (10). Replacement of major component or substantial structural part; personal
property. G is a common carrier that owns a fleet of petroleum hauling trucks. G pays
amounts to replace the existing engine, cab, and petroleum tank with a new engine, cab,
and tank. Assume the tractor of the truck (which includes the cab and the engine) is a
single unit of property and that the trailer (which contains the petroleum tank) is a
separate unit of property. The new engine and the cab each constitute a part or
combination of parts that comprise a major component of G's tractor, because they
perform a discrete and critical function in the operation of the tractor. In addition, the cab
constitutes a part or combination of parts that comprise a substantial structural part of G's
tractor. Therefore, the amounts paid for the replacement of the engine and the cab must
be capitalized under paragraph (k)(1)(vi) of this section. Moreover, the new petroleum
tank constitutes a part or combination of parts that comprise a major component and a
substantial structural part of the trailer. Accordingly, the amounts paid for the
replacement of the tank also must be capitalized under paragraph (k)(1)(vi) of this
section.
Example (11). Repair performed during restoration. Assume the same facts as in Example
10, except that, at the same time the engine and cab of the tractor are replaced, G pays
amounts to paint the cab of the tractor with its company logo and to fix a broken taillight
on the tractor. The repair of the broken taillight and the painting of the cab generally are
deductible expenses under §1.162-4. However, under paragraph (g)(1)(i) of this section, a
taxpayer must capitalize all the direct costs of an improvement and all the indirect costs
that directly benefit or are incurred by reason of an improvement. Repairs and
maintenance that do not directly benefit or are not incurred by reason of an improvement
are not required to be capitalized under section 263(a), regardless of whether they are
made at the same time as an improvement. For the amounts paid to paint the logo on the
cab, G's need to paint the logo arose from the replacement of the cab with a new cab.
Therefore, under paragraph (g)(1)(i) of this section, G must capitalize the amounts paid to
paint the cab as part of the improvement to the tractor because these amounts directly
benefit and are incurred by reason of the restoration of the tractor. The amounts paid to
repair the broken taillight are not for the replacement of a major component, do not
directly benefit, and are not incurred by reason of the replacement of the cab or the
engine under paragraph (g)(1)(i) of this section, even though the repair was performed at
the same time as these replacements. Thus, G is not required to capitalize the amounts
paid to repair the broken taillight.
Example (12). Related amounts to replace major component or substantial structural part;
personal property.
(i) H owns a retail gasoline station, consisting of a paved area used for automobile
access to the pumps and parking areas, a building used to market gasoline, and a
canopy covering the gasoline pumps. The premises also consist of underground
storage tanks (USTs) that are connected by piping to the pumps and are part of the
gasoline pumping system used in the immediate retail sale of gas. The USTs are
components of the gasoline pumping system. To comply with regulations issued
by the Environmental Protection Agency, H is required to remove and replace
leaking USTs. In Year 1, H hires a contractor to perform the removal and
replacement, which consists of removing the old tanks and installing new tanks
with leak detection systems. The removal of the old tanks includes removing the
paving material covering the tanks, excavating a hole large enough to gain access
to the old tanks, disconnecting any strapping and pipe connections to the old
tanks, and lifting the old tanks out of the hole. Installation of the new tanks
includes placement of a liner in the excavated hole, placement of the new tanks,
installation of a leak detection system, installation of an overfill system,
connection of the tanks to the pipes leading to the pumps, backfilling of the hole,
and replacement of the paving. H also is required to pay a permit fee to the county
to undertake the installation of the new tanks.
(ii) H pays the permit fee to the county on October 15, Year 1. On December 15,
Year 1, the contractor completes the removal of the old USTs and bills H for the
costs of removal. On January 15, Year 2, the contractor completes the installation
of the new USTs and bills H for the remainder of the work. Assume that H
computes its taxes on a calendar year basis and H's gasoline pumping system is
the unit of property. Under paragraph (k)(1)(vi) of this section, H must capitalize
the amounts paid to replace the USTs as a restoration to the gasoline pumping
system because the USTs are parts or combinations of parts that comprise a major
component and substantial structural part of the gasoline pumping system.
Moreover, under paragraph (g)(2) of this section, H must capitalize the costs of
removing the old USTs because H has not taken a loss on the disposition of the
USTs, and the amounts to remove the USTs directly benefit and are incurred by
reason of the restoration of, and improvement to, the gasoline pumping system. In
addition, under paragraph (g)(1) of this section, H must capitalize the permit fees
because they directly benefit and are incurred by reason of the improvement to the
gasoline pumping system. Finally, under paragraph (g)(3) of this section, H must
capitalize the related amounts paid to improve the gasoline pumping system,
including the permit fees, the amount paid to remove the old USTs, and the
amount paid to install the new USTs, even though the amounts were separately
invoiced, paid to different parties, and incurred in different tax years.
Example (13). Not replacement of major component; incidental. J owns a machine shop
in which it makes dies used by manufacturers. In Year 1, J purchased a drill press for use
in its production process. In Year 3, J discovers that the power switch assembly, which
controls the supply of electric power to the drill press, has become damaged and cannot
operate. To correct this problem, J pays amounts to replace the power switch assembly
with comparable and commercially available replacement parts. Assume that the drill
press is a unit of property under paragraph (e) of this section and the power switch
assembly is a small component of the drill press that may be removed and installed with
relative ease. The power switch assembly is not a major component of the unit of
property under paragraph (k)(6)(i)(A) of this section because, although the power
assembly may affect the function of J's drill press by controlling the supply of electric
power, the power assembly is an incidental component of the drill press. In addition, the
power assembly is not a substantial structural part of J's drill press under paragraph
(k)(6)(i)(B) of this section. Therefore, J is not required to capitalize the costs to replace
the power switch assembly under paragraph (k)(1)(vi) of this section.
Example (14). Replacement of major component or substantial structural part; roof. K
owns a manufacturing building. K discovers several leaks in the roof of the building and
hires a contractor to inspect and fix the roof. The contractor discovers that a major
portion of the decking has rotted and recommends the replacement of the entire roof. K
pays the contractor to replace the entire roof, including the decking, insulation, asphalt,
and various coatings. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is
paid to improve a building if the amount is paid to restore the building structure or any
building system. The roof is part of the building structure as defined under paragraph
(e)(2)(ii)(A) of this section. Because the entire roof performs a discrete and critical
function in the building structure, the roof comprises a major component of the building
structure under paragraph (k)(6)(ii)(A) of this section. In addition, because the roof
comprises a large portion of the physical structure of the building structure, the roof
comprises a substantial structural part of the building structure under paragraph
(k)(6)(ii)(B) of this section. Therefore, under either analysis, K must treat the amount
paid to replace the roof as a restoration of the building under paragraphs (k)(1)(vi) and
(k)(2) of this section and must capitalize the amount paid as an improvement under
paragraph (d)(2) of this section.
Example (15). Not replacement of major component or substantial structural part; roof
membrane. L owns a building in which it conducts its retail business. The roof decking
over L's building is covered with a waterproof rubber membrane. Over time, the rubber
membrane begins to wear, and L begins to experience leaks into its retail premises.
However, the building is still functioning in L's business. To eliminate the problems, a
contractor recommends that L replace the membrane on the roof with a new rubber
membrane. Accordingly, L pays the contractor to strip the original membrane and replace
it with a new rubber membrane. The new membrane is comparable to the original
membrane but corrects the leakage problems. Under paragraphs (e)(2)(ii) and (k)(2) of
this section, an amount is paid to improve a building if the amount is paid to restore the
building structure or any building system. The roof, including the membrane, is part of
the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Because the
entire roof performs a discrete and critical function in the building structure, the roof
comprises a major component of the building structure under paragraph (k)(6)(ii)(A) of
this section. Although the replacement membrane may aid in the function of the building
structure, it does not, by itself, comprise a significant portion of the roof major
component under paragraph (k)(6)(ii)(A) of this section. In addition, the replacement
membrane does not comprise a substantial structural part of L's building structure under
paragraph (k)(6)(ii)(B) of this section. Therefore, L is not required to capitalize the
amount paid to replace the membrane as a restoration of the building under paragraph
(k)(1)(vi) of this section.
Example (16). Not a replacement of major component or substantial structural part;
HVAC system. M owns a building in which it operates an office that provides medical
services. The building contains one HVAC system, which is comprised of three furnaces,
three air conditioning units, and duct work that runs throughout the building to distribute
the hot or cold air throughout the building. One furnace in M's building breaks down, and
M pays an amount to replace it with a new furnace. Under paragraphs (e)(2)(ii) and (k)(2)
of this section, an amount is paid to improve a building if the amount is paid to restore
the building structure or any building system. The HVAC system, including the furnaces,
is a building system under paragraph (e)(2)(ii)(B)(1) of this section. As the parts that
provide the heating function in the system, the three furnaces, together, perform a discrete
and critical function in the operation of the HVAC system and are therefore a major
component of the HVAC system under paragraph (k)(6)(i)(A) of this section. However,
the single furnace is not a significant portion of this major component of the HVAC
system under paragraph (k)(6)(ii)(A) of this section, or a substantial structural part of the
HVAC system under paragraph (k)(6)(ii)(B) of this section. Therefore, M is not required
to treat the amount paid to replace the furnace as a restoration of the building under
paragraph (k)(1)(vi) of this section.
Example (17). Replacement of major component or substantial structural part; HVAC
system. N owns a large office building in which it provides consulting services. The
building contains one HVAC system, which is comprised of one chiller unit, one boiler,
pumps, duct work, diffusers, air handlers, outside air intake, and a cooling tower. The
chiller unit includes the compressor, evaporator, condenser, and expansion valve, and it
functions to cool the water used to generate air conditioning throughout the building. N
pays an amount to replace the chiller with a comparable unit. Under paragraphs (e)(2)(ii)
and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to
restore the building structure or any building system. The HVAC system, including the
chiller unit, is a building system under paragraph (e)(2)(ii)(B)(1) of this section. The
chiller unit performs a discrete and critical function in the operation of the HVAC system
because it provides the cooling mechanism for the entire system. Therefore, the chiller
unit is a major component of the HVAC system under paragraph (k)(6)(ii)(A) of this
section. Because the chiller unit comprises a major component of a building system, N
must treat the amount paid to replace the chiller unit as a restoration to the building under
paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an
improvement to the building under paragraph (d)(2) of this section.
Example (18). Not replacement of major component or substantial structural part; HVAC
system. O owns an office building that it uses to provide services to customers. The
building contains a HVAC system that incorporates ten roof-mounted units that provide
heating and air conditioning for the building. The HVAC system also consists of controls
for the entire system and duct work that distributes the heated or cooled air to the various
spaces in the building's interior. O begins to experience climate control problems in
various offices throughout the office building and consults with a contractor to determine
the cause. The contractor recommends that O replace three of the roof-mounted heating
and cooling units. O pays an amount to replace the three specified units. No work is
performed on the other roof-mounted heating and cooling units, the duct work, or the
controls. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to
improve a building if the amount restores the building structure or any building system.
The HVAC system, including the 10 roof-mounted heating and cooling units, is a
building system under paragraph (e)(2)(ii)(B)(1) of this section. As the components that
generate the heat and the air conditioning in the HVAC system, the 10 roof-mounted
units, together, perform a discrete and critical function in the operation of the HVAC
system and, therefore, are a major component of the HVAC system under paragraph
(k)(6)(ii)(A) of this section. The three roof-mounted heating and cooling units are not a
significant portion of a major component of the HVAC system under (k)(6)(ii)(A) of this
section, or a substantial structural part of the HVAC system, under paragraph
(k)(6)(ii)(B) of this section. Accordingly, O is not required to treat the amount paid to
replace the three roof-mounted heating and cooling units as a restoration of the building
under paragraph (k)(1)(iv) of this section.
Example (19). Replacement of major component or substantial structural part; fire
protection system. P owns a building that it uses to operate its business. P pays an amount
to replace the sprinkler system in the building with a new sprinkler system. Under
paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if
the amount restores the building structure or any building system. The fire protection and
alarm system, including the sprinkler system, is a building system under paragraph
(e)(2)(ii)(B)(6) of this section. As the component that provides the fire suppression
mechanism in the system, the sprinkler system performs a discrete and critical function in
the operation of the fire protection and alarm system and is therefore a major component
of the system under paragraph (k)(6)(ii)(A) of this section. Because the sprinkler system
comprises a major component of a building system, P must treat the amount paid to
replace the sprinkler system as restoration to the building unit of property under
paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an
improvement to the building under paragraph (d)(2) of this section.
Example (20). Replacement of major component or substantial structural part; electrical
system. Q owns a building that it uses to operate its business. Q pays an amount to
replace the wiring throughout the building with new wiring that meets building code
requirements. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to
improve a building if the amount restores the building structure or any building system.
The electrical system, including the wiring, is a building system under paragraph
(e)(2)(ii)(B)(3) of this section. As the component that distributes the electricity
throughout the system, the wiring performs a discrete and critical function in the
operation of the electrical system under paragraph (k)(6)(ii)(A) of this section. The
wiring also comprises a large portion of the physical structure of the electrical system
under paragraph (k)(6)(ii)(B) of this section. Because the wiring comprises a major
component and a substantial structural part of a building system, Q must treat the amount
paid to replace the wiring as a restoration to the building under paragraphs (k)(1)(vi) and
(k)(2) of this section and must capitalize the amount paid as an improvement to the
building under paragraph (d)(2) of this section.
Example (21). Not a replacement of major component or substantial structural part;
electrical system. R owns a building that it uses to operate its business. R pays an amount
to replace 30 percent of the wiring throughout the building with new wiring that meets
building code requirements. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an
amount is paid to improve a building if the amount restores the building structure or any
building system. The electrical system, including the wiring, is a building system under
paragraph (e)(2)(ii)(B)(3) of this section. All the wiring in the building comprises a major
component because it performs a discrete and critical function in the operation of the
electrical system. However, the portion of the wiring that was replaced is not a significant
portion of the wiring major component under paragraph (k)(6)(ii)(A) of this section, nor
does it comprise a substantial structural part of the electrical system under paragraph
(k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the
replacement of 30 percent of the wiring is not the replacement of a major component or
substantial structural part of the building, and R is not required to treat the amount paid to
replace 30 percent of the wiring as a restoration to the building under paragraph (k)(1)(iv)
of this section.
Example (22). Replacement of major component or substantial structural part; plumbing
system. S owns a building in which it conducts a retail business. The retail building has
three floors. The retail building has men's and women's restrooms on two of the three
floors. S decides to update the restrooms by paying an amount to replace the plumbing
fixtures in all of the restrooms, including all the toilets and sinks, with modern style
plumbing fixtures of similar quality and function. S does not replace the pipes connecting
the fixtures to the building's plumbing system. Under paragraphs (e)(2)(ii) and (k)(2) of
this section, an amount is paid to improve a building if the amount restores the building
structure or any building system. The plumbing system, including the plumbing fixtures,
is a building system under paragraph (e)(2)(ii)(B)(2) of this section. All the toilets
together perform a discrete and critical function in the operation of the plumbing system,
and all the sinks, together, also perform a discrete and critical function in the operation of
the plumbing system. Therefore, under paragraph (k)(6)(ii)(A) of this section, all the
toilets comprise a major component of the plumbing system, and all the sinks comprise a
major component of the plumbing system. Accordingly, S must treat the amount paid to
replace all of the toilets and all of the sinks as a restoration of the building under
paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an
improvement to the building under paragraph (d)(2) of this section.
Example (23). Not replacement of major component or substantial structural part;
plumbing system. Assume the same facts as Example 22 except that S does not update all
the bathroom fixtures. Instead, S only pays an amount to replace 8 of the total of 20 sinks
located in the various restrooms. The 8 replaced sinks, by themselves, do not comprise a
significant portion of a major component (the 20 sinks) of the plumbing system under
paragraph (k)(6)(ii)(A) of this section nor do they comprise a large portion of the physical
structure of the plumbing system under paragraph (k)(6)(ii)(B) of this section. Therefore,
under paragraph (k)(6) of this section, the replacement of the eight sinks does not
constitute the replacement of a major component or substantial structural part of the
building, and S is not required to treat the amount paid to replace the eight sinks as a
restoration of a building under paragraph (k)(1)(iv) of this section.
Example (24). Replacement of major component or substantial structural part; plumbing
system.
(i) T owns and operates a hotel building. T decides that, to attract customers and
to remain competitive, it needs to update the guest rooms in its facility.
Accordingly, T pays amounts to replace the bathtubs, toilets, and sinks, and to
repair, repaint, and retile the bathroom walls and floors, which is necessitated by
the installation of the new plumbing components. The replacement bathtubs,
toilets, sinks, and tile are new and in a different style, but are similar in function
and quality to the replaced items. T also pays amounts to replace certain section
1245 property, such as the guest room furniture, carpeting, drapes, table lamps,
and partition walls separating the bathroom area. T completes this work on two
floors at a time, closing those floors and leaving the rest of the hotel open for
business. In Year 1, T pays amounts to perform the updates for 4 of the 20 hotel
room floors and expects to complete the renovation of the remaining rooms over
the next two years.
(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to
improve a building if the amount restores the building structure or any building
system. The plumbing system, including the bathtubs, toilets, and sinks, is a
building system under paragraph (e)(2)(ii)(B)(2) of this section. All the bathtubs,
together, all the toilets, together, and all the sinks together in the hotel building
perform discrete and critical functions in the operation of the plumbing system
under paragraph (k)(6)(ii)(A) of this section and comprise a large portion of the
physical structure of the plumbing system under paragraph (k)(6)(ii)(B) of this
section. Therefore, under paragraph (k)(6)(ii) of this section, these plumbing
components comprise major components and substantial structural parts of the
plumbing system, and T must treat the amount paid to replace these plumbing
components as a restoration of, and improvement to, the building under
paragraphs (k)(1)(vi) and (k)(2) of this section. In addition, under paragraph
(g)(1)(i) of this section, T must treat the costs of repairing, repainting, and retiling
the bathroom walls and floors as improvement costs because these costs directly
benefit and are incurred by reason of the improvement to the building. Further,
under paragraph (g)(3) of this section, T must treat the costs incurred in Years 1,
2, and 3 for the bathroom remodeling as improvement costs, even though they are
incurred over a period of several taxable years, because they are related amounts
paid to improve the building unit of property. Accordingly, under paragraph
(d)(2) of this section, T must treat all the amounts it incurs to update its hotel
restrooms as an improvement to the hotel building and capitalize these amounts.
In addition, under §1.263(a)-2 of the regulations, T must capitalize the amounts
paid to acquire and install each section 1245 property.
Example (25). Not replacement of major component or substantial structural part;
windows. U owns a large office building that it uses to provide office space for
employees that manage U's operations. The building has 300 exterior windows that
represent 25 percent of the total surface area of the building. In Year 1, U pays an amount
to replace 100 of the exterior windows that had become damaged. At the time of these
replacements, U has no plans to replace any other windows in the near future. Under
paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if
the amount restores the building structure or any building system. The exterior windows
are part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section.
The 300 exterior windows perform a discrete and critical function in the operation of the
building structure and are, therefore, a major component of the building structure under
paragraph (k)(6)(i)(A) of this section. However, the 100 windows do not comprise a
significant portion of this major component of the building structure under paragraph
(k)(6)(ii)(A) of this section or a substantial structural part of the building structure under
paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section,
the replacement of the 100 windows does not constitute the replacement of a major
component or substantial structural part of the building, and U is not required to treat the
amount paid to replace the 100 windows as restoration of the building under paragraph
(k)(1)(iv) of this section.
Example (26). Replacement of major component; windows. Assume the same facts as
Example 25, except that that U replaces 200 of the 300 windows on the building. The 300
exterior windows perform a discrete and critical function in the operation of the building
structure and are, therefore, a major component of the building structure under paragraph
(k)(6)(i)(A) of this section. The 200 windows comprise a significant portion of this major
component of the building structure under paragraph (k)(6)(ii)(A) of this section.
Therefore, under paragraph (k)(6) of this section, the replacement of the 200 windows
comprise the replacement of a major component of the building structure. Accordingly, U
must treat the amount paid to replace the 200 windows as a restoration of the building
under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid
as an improvement to the building under paragraph (d)(2) of this section.
Example (27). Replacement of substantial structural part; windows. Assume the same
facts as Example 25, except that the building is a modern design and the 300 windows
represent 90 percent of the total surface area of the building. U replaces 100 of the 300
windows on the building. The 300 exterior windows perform a discrete and critical
function in the operation of the building structure and are, therefore, a major component
of the building structure under paragraph (k)(6)(i)(A) of this section. The 100 windows
do not comprise a significant portion of this major component of the building structure
under paragraph (k)(6)(ii)(A) of this section, however, they do comprise a substantial
structural part of the building structure under paragraph (k)(6)(ii)(B) of this section.
Therefore, under paragraph (k)(6) of this section, the replacement of the 100 windows
comprise the replacement of a substantial structural part of the building structure.
Accordingly, U must treat the amount paid to replace the 100 windows as a restoration of
the building unit of property under paragraphs (k)(1)(vi) and (k)(2) of this section and
must capitalize the amount paid as an improvement to the building under paragraph
(d)(2) of this section.
Example (28). Not replacement of major component or substantial structural part; floors.
V owns and operates a hotel building. V decides to refresh the appearance of the hotel
lobby by replacing the floors in the lobby. The hotel lobby comprises less than 10 percent
of the square footage of the entire hotel building. V pays an amount to replace the wood
flooring in the lobby with new wood flooring of a similar quality. V did not replace any
other flooring in the building. Assume that the wood flooring constitutes section 1250
property. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to
improve a building if the amount restores the building structure or any building system.
The wood flooring is part of the building structure under paragraph (e)(2)(ii)(A) of this
section. All the floors in the hotel building comprise a major component of the building
structure because they perform a discrete and critical function in the operation of the
building structure. However, the lobby floors are not a significant portion of a major
component (that is, all the floors) under paragraph (k)(6)(ii)(A) of this section, nor do the
lobby floors comprise a substantial structural part of the building structure under
paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section,
the replacement of the lobby floors is not the replacement of a major component or
substantial structural part of the building unit of property, and V is not required to treat
the amount paid for the replacement of the lobby floors as a restoration to the building
under paragraph (k)(1)(iv) of this section.
Example (29). Replacement of major component or substantial structural part; floors.
Assume the same facts as Example 28, except that V decides to refresh the appearance of
all the public areas of the hotel building by replacing all the floors in the public areas. To
that end, V pays an amount to replace all the wood floors in all the public areas of the
hotel building with new wood floors. The public areas include the lobby, the hallways,
the meeting rooms, the ballrooms, and other public rooms throughout the hotel interiors.
The public areas comprise approximately 40 percent of the square footage of the entire
hotel building. All the floors in the hotel building comprise a major component of the
building structure because they perform a discrete and critical function in the operation of
the building structure. The floors in all the public areas of the hotel comprise a significant
portion of a major component (that is, all the building floors) of the building structure.
Therefore, under paragraph (k)(6)(ii)(A) of this section, the replacement of all the public
area floors constitutes the replacement of a major component of the building structure.
Accordingly, V must treat the amount paid to replace the public area floors as a
restoration of the building unit of property under paragraphs (k)(1)(vi) and (k)(2) of this
section and must capitalize the amounts as an improvement to the building under
paragraph (d)(2) of this section.
Example (30). Replacement with no disposition.
(i) X owns an office building with four elevators serving all floors in the building.
X replaces one of the elevators. The elevator is a structural component of the
office building. X chooses to apply §1.168(i)-8 to taxable years beginning on or
after January 1, 2012, and before the applicability date of the final regulations. In
accordance with § 1.168(i)-8(c)(4)(ii)(A), the office building (including its
structural components) is the asset for tax disposition purposes. X does not treat
the structural components of the office building as assets under Prop. Reg.
§1.168(i)-8(c)(4)(iii) (September 19, 2013). X also does not make the partial
disposition election provided under §1.168(i)-8(d)(2), for the elevator. Thus, the
retirement of the replaced elevator is not a disposition under section 168, and no
loss is taken into account for purposes of paragraph (k)(1)(i) of this section.
(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to
improve a building if the amount restores the building structure or any building
system. The elevator system, including all four elevators, is a building system
under paragraph (e)(2)(ii)(B)(5) of this section. The replacement elevator does not
perform a discrete and critical function in the operation of elevator system under
paragraph (k)(6)(ii)(A) of this section nor does it comprise a large portion of the
physical structure of the elevator system under paragraph (k)(6)(ii)(B) of this
section. Therefore, under paragraph (k)(6) of this section, the replacement
elevator does not constitute the replacement of a major component or substantial
structural part of the elevator system. Accordingly, X is not required to treat the
amount paid to replace the elevator as a restoration to the building under either
paragraph (k)(1)(i) or paragraph (k)(1)(vi) of this section.
Example (31). Replacement with disposition. The facts are the same as in Example 30,
except X makes the partial disposition election provided under paragraph §1.168(i)8(d)(2), for the elevator. Although the office building (including its structural
components) is the asset for disposition purposes, the result of X making the partial
disposition election for the elevator is that the retirement of the replaced elevator is a
disposition. Thus, depreciation for the retired elevator ceases at the time of its retirement
(taking into account the applicable convention), and X recognizes a loss upon this
retirement. Accordingly, X must treat the amount paid to replace the elevator as a
restoration of the building under paragraphs (k)(1)(i) and (k)(2) of this section and must
capitalize the amount paid as an improvement to the building under paragraph (d)(2) of
this section. In addition, the replacement elevator is treated as a separate asset for tax
disposition purposes pursuant to §1.168(i)-8(c)(4)(ii)(D), and for depreciation purposes
pursuant to section 168(i)(6).